Category: Equity

Cenovus Energy’s relatively small dividend

Cenovus Energy (TSX: CVE) is Canada’s second largest oil producer (behind CNQ), featuring two flagship oil sands projects, Christina Lake and Foster Creek. Unlike CNQ, they have downstream capacity just a shade short of their production levels. Needless to say they have been producing a lot of cash flow.

Compared to the top three (CNQ, Suncor and CVE), Cenovus’ dividend has been relatively paltry – the yield has been less than 2% and a very small fraction of the company’s free cash flow.

You might have been wondering why, and it likely concerns the warrant indenture. Specifically, the warrants have a price adjustment if “Dividends paid in the ordinary course” exceeds a certain level:

in the aggregate, the greater of: (i) (a) for the 2021 financial year, $170 million; and (b) for financial years after 2021, 150% of the aggregate amount of the dividends paid by the Corporation on its Common Shares in its immediately preceding financial year which were Dividends Paid in the Ordinary Course for such preceding year;
(ii) 100% of the retained earnings of the Corporation as at the end of its immediately preceding financial year; and
(iii) 100% of the aggregate consolidated net earnings of the Corporation, determined before computation of extraordinary items but after dividends paid on all Common Shares and first preferred shares of the Corporation, for its immediately preceding financial year, in each case calculated in accordance with Canadian generally accepted accounting principles consistent with those applied in the preparation of the most recently completed audited consolidated financial statements of the Corporation;

The relevant clause for 2021 is retained earnings, and it was $878 million at the end of 2021. $878 million divided by 2.016 billion shares outstanding gives you about 43 cents per share, and CVE’s current dividend was raised to 42 cents per share.

For the first half of 2022, retained earnings is sitting at $4.6 billion and this will likely go much higher by year-end. At June 30, CVE had 1.97 billion shares outstanding and thus they can practically increase their regular dividend to match their cash flow once the audited financial statements are released in March of 2023. Until then, they are stuck with their existing dividend and are busy buying back shares and paying down debt in the meantime, in addition to consolidating the 50% share in the Sunrise oil sands and Toledo refinery that they previously did not own. Once they get down to their $4 billion debt target, the company pledged to distribute 100% of its earnings to shareholders – practically behaving like an income trust if you remember those days when Penn West and Pengrowth income trusts were throwing out the cashflow in a similar manner. An annualized $2/share dividend is not out of the question, and this would likely result in the stock trading for higher than what it is currently trading for today.

Today’s contrarian sector – European Banks

This is likely in the “not yet” category, but it is something that I’m paying a little more attention to than most, namely the big European banks.

With the EU reacting to its poor energy policies by enacting demand restrictions, there will surely be further reverberations going forward in terms of the continent’s heavy industry. This will have spin-off impacts in terms of the credit that is extended to various corporations that are sensitive to energy input costs, and creating a whole financial cascade. Who ever thought that negative interest rates would actually have real consequences?

With that said, I’ve looked at various European banking entities, and just doing the most superficial analysis. Numbers are market cap (US billions), P/E, P/B and historical dividend yield.

UK
LYG: Lloyds Banking Group – 33 / 6.6 / 0.57 / 3.9%
BCS: Barclays PLC – 31 / 5.1 / 0.38 / 2.8%

France
BNPQY: BNP Paribas – 57 / 5.6 / 0.49 / 8.5%
SCGLY: Societe Generale – 18 / 7.0 / 0.28 / 8.0%

Germany
DB: Deutsche Bank – 17 / 5.4 / 0.25 / 2.7%
CRZBY: Commerzbank – 8 / 4.9 / 0.28 / 0%

Italy
ISNPY: Intesa Sanpaolo – 33 / 8.8 / 0.51 / 7.0%
UNCRY: Unicredit – 19 / 25.6 / 0.30 / 3.9%

Spain
SAN: Banco Santander – 39 / 4.6 / 0.44 / 4.6%
BBVA: Banco Bilbao Vizcaya Argentaria – 28 / 4.6 / 0.62 / 11.3%

Scandinavia
NRDBY: Nordea Bank (Finland) – 34 / 10 / 1.1 / 16.7%
DNBBY: DNB Bank (Norway) – 29 / 9.9 / 1.17 / 5.6%
SVNLY: Svenska Handelsbanken (Sweden) – 16 / 7.4 / 0.89 / 6.8%

Other notables
UBS: UBS Group (Switzerland) – 55 / 7.0 / 0.97 / 1.6%
ING: ING Group (Netherlands) – 32 / 7.8 / 0.62 / 4.0%

Note that all of the institutions above have international operations and hence they are not entirely exposed to the risks of their domestic markets.

Let’s compare this to Canada (market cap is in billions of USD):

Canada
RY: Royal Bank: 130 / 10.8 / 1.8 / 4.2%
TD: Toronto Dominion: 118 / 10.7 / 1.6 / 4.2%
BMO: Bank of Montreal: 63 / 7.3 / 1.7 / 4.6%
BNS: Bank of Nova Scotia: 65 / 8.7 / 1.3 / 5.8%
CM: Canadian Imperial Bank of Commerce: 43 / 9.4 / 1.3 / 5.4%

One immediate observation is that Canadian banks have much larger market capitalization than their European counterparts. Indeed, looking at the global picture, the USA and China have the largest banks by market capitalization, while the largest European one is BNP, very much behind in the standings.

Needless to say, some of these European bank valuations look compelling at a glance. However, to do the proper analysis of these large (and for the most part, incredibly opaque) institutions, one has to have a grasp on whether their loan portfolios will actually perform and to get a sense of where the geopolitical risks lie. But overall, Europe is trading like a disaster at the moment for obvious reasons (they are a slow-moving financial train wreck happening at the present time) – if, for whatever reason, it is better than a disaster, there perhaps may be some gains to be had in the future from the current depressed levels.

Unfortunately I am not skilled enough to make a nuanced differentiated bet on any specific company above – there are tons of analysts working in the usual institutions that are properly able to gain an edge on which of the above will do better than the rest, but my suspicion is that at some point, an unsophisticated player like myself can probably generate some alpha by constructing an equal-weighted ETF of some of the components above.

I do think I have a better “home field advantage” with the Canadian banks above, but that home field advantage tells me to back off for better values in the future. As far as Europe goes, however, the time is likely closer to a reasonable value bet.

That said, you may wish to disregard anything I say on international bank stocks simply because it does not look like that my investment in Sberbank (a couple days before the sanctions hit) will be materializing anytime soon – my largest one-shot loss in my investing history, assuming it goes to zero (which it effectively is at the moment for non-Russian investors).

Yellow Pages’ peculiar share buyback

Yellow Pages (TSX: Y), a long-time holding of mine, announced their second quarter results a couple weeks ago.

There were some interesting highlights involved, namely that this quarter was the first quarter in a very, very, VERY long time where they had a sequential increase in revenues between quarters (albeit, the profitability of such revenues decreased as the mix had more lower margin revenues). This got very little recognition.

The actual cash generation figures have still been quite healthy, although this is the first full year where Yellow’s tax shield has whittled away to only partially offset their income. By virtue of making some seriously questionable past acquisitions (before the belt-tightening regime of the existing management) they are allowed to deduct a declining balance amount on their cumulative eligible property, which is better than nothing.

However, the highlight is what is essentially a forced share buyback:

The Board has approved a distribution to shareholders of approximately $100 million by way of a share repurchase from all shareholders pursuant to a statutory arrangement under the Business Corporations Act ( British Columbia ). The arrangement will be effected pursuant to a plan of arrangement which provides that the Company will repurchase from shareholders pro rata an aggregate of 7,949,125 common shares at a purchase price of $12.58 per share, which represents the volume weighted average price for the five consecutive trading days ending the trading day immediately prior to August 5, 2022.

The proposal requires 2/3rds of the shareholders to approve, but they already have consent from the three major shareholders (GoldenTree with 31%, Empyrean with 24% and Canso with 23%) to proceed. Minority shareholders (such as myself) are along for the ride, although because the buyback is proportional, no entity will have a different level of ownership after the transaction (restricted share units, options, etc., typically have clauses to reflect such special distributions).

At the end of June 30, Yellow had 26,607,424 shares outstanding. This works out to a distribution of $3.76/share.

The way I understand it, instead of the entire amount consisting of an eligible dividend, it will effectively amount to a sale of 30% of the stock, which means that the cost basis of such shares can be deducted against the proceeds of the sale (for most people, this will be a capital gain). If my understanding of the tax treatment is correct, then the tax burden of such a distribution will be significantly less than the typical special dividend.

However, in the letter to the three top shareholders, the following paragraph is in there:

The Company agrees that it shall designate the full amount of any dividend deemed to arise under the Income Tax Act (Canada) as a result of the acquisition of the Common Shares pursuant to the Arrangement as an “eligible dividend” pursuant to subsection 89(14) of the Income Tax Act (Canada) and the corresponding provisions of any provincial tax legislation pertaining to eligible dividends.

As those three entities own more than 10% of the common stock of the company, such a distribution would be tax-free if given to their CCPC subsidiaries if classified as such. I am not sure whether differential tax treatment is permitting. When the company’s management information circular comes out, reading the tax opinion will be educational as I have never encountered this ‘forced buyback’ in my investing life.

Whitecap’s acquisition of XTO Energy’s Canadian assets

Whitecap Energy (TSX: WCP) yesterday announced a $1.9 billion cash ($1.7 billion net of working capital) acquisition of XTO Energy’s Canadian operations, which involves a huge chunk of land and operating assets in the northwestern portion of Alberta, in addition to a gas processing plant. This deal is much more gas-weighted than liquid-weighted.

This deal works for Whitecap if we are in a “higher for longer” commodity price environment. They are acquiring an immediate 32 kboe/d asset at a relatively expensive price, but the lands they are acquiring have very good expansion potential, which they are targeting in 2023. In 2023, they intend to ramping up Capex from $600 million to approximately $1 billion, which means that they will be generating less free cash flow that year than they otherwise would have had they not made this acquisition. However, that would pay off in 2024 and beyond (perhaps when TMX is actually finished, and the SPR drawdown concludes and thus the WCS differential closes???)

However, this flies in the face of the general thesis for most oil and gas companies that they are generally in “maintenance” mode and they will be distributing the bulk of their cash flows to shareholders. In this particular case, Whitecap will be busy paying off the debt from the acquisition and will need the better part of 2023 to get back down to their end of Q1-2022 debt level ($1.07 billion). Specifically they will not be in the open market buying back stock over the next year. They do provide some clear milestones for shareholder returns (at a $1.8 billion debt, they will increase their dividend and at $1.3 billion, they will increase it to a projected 73 cents/share/year – projected at Q2-2023) – which would put them at an approximate 8% yield.

There is now a clear differentiation between companies that are in maintenance mode (spend the capital to maintain production, and then pay down debt and distribute proceeds to shareholders) and expansion mode. WCP is now clearly in the latter category. It works until the commodity price environment goes adverse.

The market has also soured on the deal – Whitecap traded down 6% for the day after trading initially higher. This is probably going to be a disincentive for other companies contemplating expansionary policies.

That said, if the “higher for longer” environment continues, the stock is looking cheap, along with the rest of the sector. But there is this ominous feel of the winds of recession coming, coupled with the potential end of the cycle of the industry.

In terms of valuations, it increasingly looks like that free cash flow multiples aren’t going to get much higher than present values, which suggests that the mechanism of returns for these companies will be in the form of total returns (the cash they will distribute to shareholders, coupled with the impact of open market buyback operations). It will also be very rocky.

The nature of risk has finally returned into the fossil fuel market.

Cenovus / Sunrise Oil Sand Acquisition – Analysis

Cenovus (TSX: CVE) today announced they are purchasing the remaining 50% interest in the Sunrise oil sands assets for C$600 million plus another C$600 million in contingent consideration, plus a 35% interest in the “Bay du Nord” project in Quebec, a currently undeveloped offshore project.

The contingent consideration is quarterly payments of $2.8 million for every dollar that Western Canadian Select is above CAD$52/barrel, for up to 2 years, and a maximum of C$600 million. Considering that WCS is currently at about CAD$130, this will work out to $220 a quarter. Barring a complete disaster in the oil sands, it is a virtual certainty the entire C$600 million will get paid out.

I have no idea how to value the 35% Bay du Nord project stake and will zero this out for the purposes of the following calculations.

Cenovus made a $56.20 netback in their Q1-2022 oil sands productions. Sunrise, not being the best asset on the planet, is about $15/barrel more expensive to operate and transport, so we will calculate a $41/barrel netback. However, the royalty structure is in pre-payout, compared to post-payout and hence netback will be higher by about $10/barrel. Very crudely (pun intended!) I estimate around $51 netback (estimated to last 7-8 years before the full post-payout rate kicks in). CVE will acquire 25k boe/d, so they are acquiring about $465 million of netback with $1.2 billion spent, or about a 39% return.

This does not assume that CVE will be able to scale up the operation to 60k boe/d as stated in the release, which would add another $186 million/year, or about 15% extra, ignoring the incremental capital costs of the project.

Tax-wise, CVE still has a $17.6 billion shield at the end of 2021, so the impact of income taxes will not kick in for at least a couple years. Even assuming full income taxes and ignoring the extra 10kboe/d production, CVE is purchasing something for a 30% after-tax return in today’s commodity environment. That’s pretty good for shareholders!